Evidence-Based Investing? It all Depends

Would you be surprised if I told you that 60% of packaged foods in America contain added sugar?

My guess is no, you wouldn’t be. You probably know that sugar is highly addictive. What better way to get customers hooked on your products. So its no surprise that companies load products with sugar. After all, isn’t that what you’d expect from a food producer trying to maximize their profits?

But would you conclude that its impossible to produce packaged foods without added sugar? Somehow I don’t think that you would.

In a similar way, should we be surprised that the vast majority of active fund managers under-perform the market? Just like the packaged food manufacturers, they are simply doing what it takes (or at least what it took historically*)  to attract investors and to maximize their profits.

This blog post is not a defense of active management. Far from it. Active management deserves to be criticized. The continuing loss of market share to indexing and factor-based strategies has been largely self-inflicted. Nor am I criticizing every active fund manager.  I have had the privilege of investing with a handful that are genuinely skillful.

This is a post about reasoning and logic. Under-performance is not necessarily evidence that the market can’t be beaten as a lot of commentators argue. Instead, its more likely to be evidence that many fund managers put profits before the financial health of their investors.

Why am I bringing this up? Because it’s an example of why I’m frustrated by much of the blogging and tweeting about “evidence-based investing”. There seems to be a consensus view  making its way around the internet that all of the evidence points towards indexing or factor-based investing as being the only sensible way to invest.

I don’t disagree that indexing or factor-based strategies are the sensible way to go. Nor am I arguing that the majority of individuals and institutions should attempt to pick fund managers or stocks. Frankly, most won’t succeed.

So what am I arguing? That all the “evidence” really says is that it all depends. Both academic research and empirical results show that the choice between active and passive depends on a lot of factors. In other words, the conclusion that the “evidence” points to is far more nuanced than many people would have you believe.

I may be frustrated, but I’m not surprised because nuance doesn’t sell. If you’re a fund manager or adviser (and many of the commentators are) your clients want to know what your philosophy and process is.  So you have to take a confident stand. After all, how many clients are going to hire someone whose answer to one of the fundamental investment questions about your investment approach is “it all depends”?

The name of this blog – Market Fox – was inspired by the idea that investing is all about the future and that the future is both uncertain and unknowable, which means that “it all depends” is more often than not the right answer.

If you, the reader, take anything from this post it should be this: That analysis without synthesis is of little help when it comes to investing. The evidence only gets its meaning after you have struggled to reconcile all of the opposing facts and have come up with an explanation that reconciles them.

OK enough of the sermon. Lets come back to the evidence that the significant majority of active fund managers under-perform the market. What other evidence is there that we should consider?

In 2015 Joseph Mezrich at Nomura  published a paper entitled Your Fund Managers Really Can Pick Stocks. A copy of a presentation outlining the key findings of the paper can be found here.

Nomura created a market cap-weighted index of US large cap equity managers holdings from 2004 – 2014. In other words, they made no attempt to select fund managers, they simply aggregated up all of the holdings of all of the active mutual funds to create a market cap-weighted index of mutual funds. They used the CRSP mutual fund database, which is survivorship-bias free.

Mezich and the team at Nomura then ran the results through a Fama-French-Carhart factor model. Here’s what they found:


Statistically significant (t=3.79) alpha of 2.15% per year versus the Russell 1000 after accounting for exposures to the market, size, value and momentum factors.  This is shown in the chart below, where the mutual fund holdings (dark blue) out-perform the Russell 1000 (purple) and the mutual funds themselves (light blue).


How do we synthesize this evidence with the evidence that most mutual funds under-perform the market? Remember, no attempt was made to select the “best” funds. These results reflect the performance of US large cap equity managers as a group. They are the smartest and brightest, the best-of-the-best. Supposedly they are good, and the competition is now so tough, that they’ve turned investing into the “losers game” (please see my earlier post).

The 2% out-performance happens to be more or less equivalent to the average all-in investment fee and transaction costs of the mutual fund industry.

For those interested in an academic reference, I recommend reading Five Myths of Active Portfolio Management by Professor Jonathan Berk of Stanford Graduate School of Business.

In light of this additional evidence, which conclusion do you think is more likely:

  • Most mutual funds under-perform the index because the market can’t be beaten?
  • Most mutual funds under-perform because they extract the entire value created by their collective skill in fees and costs?

Where does the evidence lead you? I hope that you’ll answer “it all depends”.



  • Most investors want to have their cake and eat it too – long-term market beating returns without short-to-medium-term under-performance.

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